Weather hedging. It’s a concept that many fuel dealers have heard over the years but relatively few have fully explored. In short, weather hedging for fuel dealers can best be described as a method to recoup some level of the lost fuel delivery and service profitability that otherwise would have been earned in a warmer than normal winter. Weather protection products are typically crafted using a mix of your company’s profitability goals and the heating degree day history specific to measurement stations in your region. They are financial derivative tools designed to counter that hackneyed refrain of helplessness we so often hear: “Hey, we can’t control the weather.”
This winter is shaping up to be unique to our industry. Not only are we heading into the heating season carrying ever higher fixed costs because of payroll increases and across-the-board leaps in equipment and other operating expenses, but fuel dealers appear to be hurtling toward a period of unusual impact on customer consumption due to very high commodity prices and painful inflation. If the market trends persist, the profit generated by each heating degree day this winter will need to cover a higher proportion of fixed cost, thereby placing greater importance on your company’s ability to achieve sustained earnings – and on your company’s ability to replace lost earnings should conditions work against it.
To bring some sanity to your financial planning approach, start by separating the issue of covering your company’s fixed costs from the domestic and international headlines whipsawing commodity prices and the stock market. Likewise, avoid making assumptions about the cost of weather hedging based on winter forecasts. Understand that the weather hedging cost (known as the “premium”) is driven by your company’s specific situation, including profit goals, the period to be protected and the ability to absorb the impact of a warm winter.
Most companies expect to earn substantial profits from November through the spring. An expected warm start to the heating season – as NOAA and others have predicted this year – is simply a forecast and, like most forecasts, can be upended dramatically as the winter progresses. For this reason, weather hedge premiums this fall remain competitive with those seen in recent years. Depending on the period of time a fuel dealer elects to protect (for example, a specific month, a few months or the entire heating season), this early warm weather bias can have very little impact on pricing. Don’t let the clutter of information such as early forecasts, rising interest rates and swings in commodity cost cloud your analysis of a weather hedge.
So, how should you approach obtaining the appropriate weather hedge quotes for your business? The best starting point is consulting your monthly profit and loss forecast for this heating season to establish your expectations in a “normal” winter, including targeted fuel gross profit, service gross profit and your most critical earnings months. If you do not have a budget, weather-normalized gallon and profit detail from recent winters can be used to design reasonable protection, but keep in mind profit goals should be raised this year due to the inflationary impact we face. Armed with this information, contact your registered hedging advisor to discuss the various structures available to you and the associated cost of each. Depending on your company’s balance sheet strength, an appropriate “strike” level (when a payout would begin) and the settlement per heating degree day will be determined to better set parameters tied to the potential damage to your company from lost deliveries and service profits due to sustained warm weather.
A common objection to purchasing a weather hedge is “cost.” While weather hedging may, in fact, be a new cost to your company, keep in mind you derive great value – and a more restful night of sleep as a manager – from a tool to help blunt the negative impact to your profits and balance sheet. History has proven that during winters of unusual warmth, margins often cannot be increased high enough to maintain appropriate profitability. Not only do your customers monitor prices, but in warm winters there is always a competitor that is happy to deliver fuel at a margin which seems completely untethered to reality. When viewed on a cents per gallon basis and factored into your margin targets ahead of the winter, our experience shows the cost can be successfully absorbed by your customer base. It eventually becomes a regular cost of doing business for consistent weather hedge clients.
Finally, recognize that your company’s financial position differs from that of your competitors. Each company in our industry is positioned differently to absorb the financial impact of a warm winter. You can design a weather hedging product that suits your company’s needs for this coming heating season – and it is not too late to do so. Taking the time now to understand the mechanics of weather hedging and how it can be tailored to your company’s profit goals costs you little more than time.
Written By Jeffrey Simpson – Former Managing Director of Angus Finance
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